Tax Free Savings Accounts

• Guides
• Published: 16 Oct 2008 in Money and Savings

The best rates of interest you are likely to get on any savings account are achieved by avoiding the obligation to pay tax on the interest earned. Although there are limits on the value of savings that can earn you tax-free interest, it is nevertheless about ensuring that you make full use of this facility up to your individual allowance, before looking at other forms of savings account.

The “tax-free” vehicles for cash savings come in the form of government-sponsored mini- (cash) ISAs, maxi-ISAs and TESSA only ISAs. What a confusing series of acronyms! Although we’ve given a brief introduction to the Individual Savings Account (ISA), and its mini and maxi variants, elsewhere, but mini- (cash) ISA’s and the cash component of maxi-ISAs offer savers an ability to save up to £3,000 each year in cash and pay no tax on the interest earned.

TESSAs and TOISAs

A TESSA only ISA (or TOISA, to add yet another acronym!) is an ISA into which all or part of the original savings investment (up to a maximum of £9,000) from an end-of-term Tax Efficient Special Savings Account (TESSA) has been invested. TESSAs first appeared in 1991 and allowed savings of up to £9,000 to be made over 5 years. If the capital amount in a TESSA remained in the account until its full term, the capital could be re-invested in a new TESSA and the interest earned by the saver would be completely free of tax. When ISAs were introduced by the government in 1999, TESSAs were withdrawn, but their holders were allowed to continue to reinvest capital from a matured TESSA into the new TOISA (retaining the original capital limit of £9,000). Only holders of the original TESSAs could purchase TOISAs and, although capital could be withdrawn from a TOISA, it could not be replaced. In addition to being able to hold a maximum-value £9,000 TOISA, investors shared the same option as new savers in being able to purchase one maxi-ISA or two mini-ISAs each year.

It should be noted that ISAs can comprise savings in the form of cash or investments in stocks and shares (equities). The maximum cash holding in an ISA in any one year is £3,000 and in a TOISA, £9,000. The maximum investment in an ISA is £7,000. It is important to remember that only the interest earned on the cash element is tax-free. Earnings from the dividends paid on any ISA-held shares are taxable at the normal rates. ISAs are therefore more strictly defined as “tax efficient” vehicles for savings and investment, rather than “tax-free”.

The pros and cons

To sum up the advantages of the “tax-free” element of mini-ISAs, maxi-ISAs and TOISAs, therefore:

- the clearest advantage is that income from interest-bearing cash in these accounts is tax-free
- interest rates are at least as good as normal savings accounts, and the tax-free benefit makes those rates even better
- some ISA’s offer variable rates of interest, tied to the base rate of the Bank of England. If the latter increase, then so too does the interest rate of the ISA
- you are able to save a maximum of £3,000 in a cash ISA in any one year.

The disadvantages are that:

- there is a maximum £3,000 that can be held in a cash ISA in any one year. If you have a greater amount than that, you must wait until the following year to buy an ISA or deposit the funds in an ordinary savings account
- government regulations allow only one ISA to be opened in a single financial year.